What is a Leveraged Buyout? How does it Work?

A leveraged buyout, commonly referred to as an LBO, is a transaction that companies use to acquire other businesses. The buyout involves a combination of equity from the buyer, along with debt that is secured by the target company’s assets. The deal is structured so that the target company’s assets and cash flows are used to pay for most of the financing cost.

Advantages of an LBO

The main advantage of a leveraged buyout to the company that is buying the business is the return on equity. Using a capital structure that has a substantial amount of debt allows them to increase returns by leveraging the seller’s assets. There can also be some tax benefits, though these are beyond the scope of this article.

From the seller’s perspective, there are advantages to using an LBO. First and foremost, it is one of the many ways that an owner can sell a business. Most sellers will go through with the LBO process as long as it allows them to exit the business at their desired price.

Leveraged buyouts also allow for the sale of companies that are in distress or going through a turnaround. They provide a viable exit to the seller while also allowing the business to continue operating while the problems are fixed.

Disadvantages of an LBO

From a buyer’s perspective, LBOs have some risks. The main disadvantage is that, once the deal is completed, the target business is very leveraged. This scenario allows for little margin of error. A problem with liquidity, such as the loss of a few key customers, could put the business in serious distress.

From a seller’s perspective as well, executing a leveraged buyout has some disadvantages. Buyers usually undertake an extensive due diligence process. This process can consume time and resources which could be spent managing the business. Furthermore, their lenders may also want to do their own due diligence, adding to the disruption. Lastly, even after all this effort, the transaction could fall through if a key lender is not comfortable with its findings.

Structure

A leveraged buyout can be structured in various ways. However, the two most common structures are:

1. The buyer purchases the assets

In this structure, the buyer purchases only the assets of the target company. The assets are placed in a new corporate entity designed to hold the assets and operate the business. Commonly, the selling company is referred to as “Oldco” (“old company”), and the new company that will hold the assets is referred to as “Newco” (“new company”).

The main advantage of this structure is that it allows the buyer to purchase the assets cleanly, limiting potential liabilities from the old company’s past activities. Note that this description is an oversimplification of the matter. In certain cases, a lawsuit could invalidate this protection.

2. The buyer purchases the whole company

Another way to purchase the company is to absorb it into the buyer’s existing company. This strategy may make sense in some circumstances, though it can open the door to future liability.

How is the purchase financed?

Most small and midsize company leveraged buyouts usually require two types of financing. The buyer needs funds to acquire the company. They also need some financing to operate and expand the business.

The type of debt that is used to acquire the company depends on a number of variables such as the financial health of the buyer and the seller, their reputations, and the size of the transaction. Larger transactions that involve well-known companies commonly use a mix of bonds, senior and mezzanine financing, and conventional bank lending.

On the other hand, smaller transactions, or those involving companies that are not well known, tend to use alternative financing options. These options include:

1. Seller financing: Many small to midsize leveraged buyout transactions have a seller-financing component. Basically, the seller takes a note from the buyer that is amortized over a period of time. Seller financing is an advantage to the buyer, since sellers tend to be more willing than banks to provide financing. This type of financing is common in smaller transactions and in management buyouts (a form of leveraged buyout).

2. Assumption of debt: In many cases, as part of the payment, the acquiring company can assume some – or all – of the target company’s debt.

3. Bank loans: Bank financing is also commonly used in small and midsize leveraged buyouts. Usually, the buyer takes a loan and uses it to cover part of the purchase price. Keep in mind that banks seldom provide 100% of the funds needed to purchase the company. They often require that the buyer use its own capital as well. Learn about business acquisition loans.

4. Asset based funding: This funding is used to secure loans against certain assets, such as real estate and machinery. This option is more common in transactions that include real estate or that have machinery that is in good condition and paid off.

How are operating costs financed?

Once you own the company, you are faced with having to pay for regular operating expenses – plus the cost of any acquisition financing. This expense can create a problem if cash flow is tight, or if the company is going through a turnaround. Most companies will need funding to help with cash flow. Common funding alternatives include:

1. Factoring: Factoring is a type of financing that allows the buyer to leverage the company’s accounts receivable. Factoring improves cash flow, which, in turn, leaves the company in a better position to make financing payments, meet payroll, or pay suppliers. Learn more about factoring.

2. Inventory financing: Inventory financing is a type of funding that lets you finance your existing, free-and-clear inventory.Your company can usually finance up to 80% of the forced sales liquidation value, or, in some instances, the net orderly liquidation value. Note that the liquidation value of inventory can be substantially lower than the price you paid for it. Learn more about inventory financing.

3. Asset based lending: Asset based lending offers a combined facility that allows you to leverage your accounts receivable, equipment, inventory, and, in some cases, property. It’s often used by larger companies as an alternative to factoring and inventory financing.Learn more about asset-based lending.

4. Bank financing: A great way to finance operations is through a line of credit, assuming that you meet the bank’s lending requirements. Lines of credit provide great flexibility at a very reasonable cost. Just remember that lines of credit have a number of covenants, including keeping certain financial ratios at a specific level. This goal may be difficult to achieve in certain leveraged buyout scenarios. Learn more about lines of credit.

Paying the seller vs. paying for operational costs

A major challenge of executing an LBO correctly is making sure the acquired company has enough working capital to operate after the transaction completes. Buyers often try to use every available asset from the seller to make the initial payment. This strategy can backfire.

It’s best to use assets such as accounts receivable and inventory to finance operations (after the sale), rather than to finance the initial acquisition. Using these assets to finance the acquisition cost could leave you without any resources to cover operating expenses. This approach could create a serious cash flow problem which could derail the whole acquisition.